Do You Have an Out-of-State Trust: Getting Your Refund After the Kimberly Rice Kaestner Case

A recent decision by the North Carolina Business Court could have significant ramifications for North Carolina’s taxation of trusts, and could result in substantial refunds for certain beneficiaries. In Kimberley Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue, the court struck down North Carolina’s statute that taxes trust income based upon the residence of the beneficiary, finding that the law violated the Constitution’s Due Process and Commerce Clauses.

The trust had no connections with the state of North Carolina exepct for the beneficiary’s residence there – all assets were kept and managed in New York. But based on a North Carolina law that taxes non-source income “of the estate or trust that is for the benefit of a resident of this State,” the trust paid $1.3 million in taxes to North Carolina between 2005 and 2008.

In 2009, the trustee filed for a refund, arguing that North Carolina’s statute violated the Commerce Clause and the Due Process clause of the United States Constitution as well as Article I, Section 19 of the North Carolina Constitution and won. The North Carolina Business Court held that North Carolina cannot validly tax assets having no “substantial nexus” to the state.

If upheld, the implications of the Kaestner decision may be significant both for trusts held for the benefit of North Carolina residents, and, of course, for the state’s coffers. The North Carolina Department of Revenue’s current practice is to tax assets held in trust for the benefit of resident beneficiaries regardless of the situs of the trust, including trusts in which only secondary beneficiaries live in North Carolina. For non-source income of irrevocable, out of state trusts, that could all end.

Should the case survive appeal, it will have two major ramifications: first, many similarly situated trustees will file for refunds for overpayments of taxes. But considering that the statute of limitations on a tax refund in North Carolina is three years, it is important for these trustees to take action quickly. While the case is pending appeal, taxpayers would be well advised to take advantage of N.C.G.S. Section 105-241.6(b)(5), which allows for the filing of a form of protective claim “[i]f a taxpayer is subject to a contingent event and files written notice with the Secretary, the period to request a refund of an overpayment is six months after the contingent event concludes.”

Second, if the case stands it will provide a slew of planning opportunities for trusts with North Carolina beneficiaries to disentangle themselves from North Carolina. It may be possible to avoid North Carolina fiduciary income tax to the extent trust income is not distributed to North Carolina residents in a given tax year.

If you are a trustee or a beneficiary of an out-of-state trust with a North Carolina resident, be sure to speak to a qualified professional about what income you must report going forward, and whether you may be entitled to a refund of taxes wrongly paid to the State of North Carolina.